Why would you take out a loan with an interest rate that might go up? At first glance, it may not make sense for a recent graduate with a sizeable amount of student debt to choose to take on more financial risk… but in today’s low interest rate environment, interest rate risk – meaning the uncertainty about where interest rates will be in the future – may actually be a risk worth taking for certain types of borrowers.
Let’s start with the basics: how do variable rate loans work?
Variable rate loans feature an interest rate that is comprised of 1) a market rate, plus 2) a “spread” or “margin” – a fixed incremental amount of interest determined by your lender. The loan’s interest rate therefore changes as the market rate changes. This variability means that a borrower’s monthly payments may, and very likely will, change over the life of the loan.
For student loans, the standard market rate used is the 1-month London Interbank Offered Rate or “1-month LIBOR, ” as it’s more commonly known (see right inset). This past July, 1-month LIBOR was at an all-time low of 0.15% (see chart below for a historical time series).
So, a hypothetical 10-year variable rate student loan, with a rate of 1-month LIBOR plus a 4.00% spread, would have an interest rate of 4.15% during the subsequent month. Variable rate loans tied to current LIBOR represent relatively cheap financing, and therefore savings, for graduates in today’s low interest rate environment.
Variable rate vs. Fixed rate student loans
Fixed rate student loans, on the other hand, allow you to lock in one interest rate that doesn’t change over the life of the loan, thereby eliminating interest rate uncertainty for the borrower. The tradeoff for a borrower who chooses fixed rate financing over variable rate financing is that the borrower is now locked into paying a higher rate today on his/her student debt.
Why are fixed rates higher than variable rates? Today’s fixed rate loans are priced with the market’s expectation of where interest rates will be over the course of the loan’s repayment term, and the market is currently assuming that rates will increase over time.
What could increase interest rates to figures even higher than the market is currently expecting? There are nearly a zillion variables at play that may work to either increase (or decrease) market rates. In theory, the most widely considered influences on rates are the general state of the economy and the monetary policy of the Federal Reserve, but in practice, it’s not easy to forecast market rates. In fact, the idea that market rates will be increasing from their historic lows has been a popular – and so far losing – view across the professional money management community for years following the 2008-09 financial crisis.
Therefore, in the absence of a crystal ball to perfectly forecast future rates…
Is a lower interest rate on your loans ever worth the corresponding risk with a variable rate loan?
As usual in personal finance, the answer is…it depends. It depends specifically on your personal tolerance for risk and how quickly you plan on paying down your loan. Generally speaking, a variable rate loan makes sense if 1) you expect to prepay your student loans in a shorter period of time (which gives interest rate uncertainty less time to wreak havoc in a rising rate scenario) or 2) you are comfortable shouldering the extra uncertainty.
If a variable rate loan sounds like a good fit for you, we at CommonBond have you covered. We’ve introduced variable rate loans to complement our fixed rate products and provide more options for folks looking to refinance their student loans. We understand there are many types of borrowers, and we’re excited to continually expand our product set to help more people meet their various financial objectives.
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Michael Taormina is CFO & Co-Founder of CommonBond, a student lending platform that provides a better student loan experience through lower rates, exceptional customer service, and a commitment to community. CommonBond is also the first company to bring the one-for-one model to education and finance. Mike is a former VP at J.P. Morgan Asset Management and a CFA Charterholder.